First he talks about why increased resource costs are going to be a headwind.

With a few months to reconsider the data, old and new, I would have framed last quarter’s issue on declining growth differently to emphasize how routine, even friendly, most of our inputs were. The main new point I wanted to make was that resource costs are treated like GDP increases. Hence, prior to 2002, steadily falling resource costs were treated as a debit when of course steadily lower costs were a great help to well-being and utility. We calculated that adjusted GDP actually grew 0.2% a year faster than stated. Conversely, since 2000, rising costs were a detriment, not a benefit, as shown in GDP. Treated correctly as a negative, resource costs would have reduced real growth by 0.4% a year. This squeeze on growth will continue as long as resource costs rise faster than the growth rate of the balance of the economy. Further, as the percentage of the GDP taken up by resources has recently more than doubled (2002 to 2012), the squeeze on the balance of the economy would also be doubled even if the rate of cost increases stayed constant. Last quarter I estimated that continued increases in resource costs from now to 2050 would lower GDP growth by 0.5%. To prevent that 0.5% effect from accelerating as the share of resources in GDP rises, the rate of resource cost increases must decelerate from the recent 7% a year to a much more modest 2% a year by 2050. (By then, of course, it might well be over the current 7% … it is just not knowable.) As one can see, this is not nearly as draconian an assumption as it might initially appear to be and in this context it is worth remembering that we don’t really know what caused resource prices to spike from 2002 to 2008 so impressively. This was a much bigger price surge than occurred during World War II! Indeed, it may easily turn out that the resource price rises will squeeze future GDP growth substantially more than our estimates.

He then throws in climate as a bigger problem down the road (Grantham is very concerned about the environment).

Although our low estimate of future GDP growth attracted attention and plenty of opposition, it was only produced as a necessary backdrop to show the potential significance of our two new points: the large deduction for a cost squeeze from resources (0.5%) and a very slight but increasing squeeze from climate damage (0.1 rising to 0.4 after 2030), which latter deduction is considered almost ludicrously conservative by that handful of economists that study the costs of climate change. Our work on the traditional aspects of GDP growth was approached by us as a necessary chore; we were not looking for trouble. Consequently, we tried to keep it simple by using the obvious data sources.

Then he goes into population and productivity:

“Where on earth did GMO get its pessimistic population data?” ran one complaint. Well, would you believe the U.S. Bureau of Census? And as for productivity, we extended the 1.3% average for the last 30 years out for 30 more years. This is clearly a very friendly assumption given: a) the recent 1.3% in productivity growth of the last 30 years had declined a lot from its 40-year surge of 1.8% after World War II; and b) the fact that the segment of much higher productivity – manufacturing – has declined to a mere 9% of total labor from 19% in 1980 and continues to decline. Even my one override, -0.2% a year for the next 18 years as a result of much-reduced capital spending, seems, based on econometric modeling, to be a very modest debit. For there to be so modest a negative effect needs capital spending to drift back toward normal in the relatively near future. And even then this -0.2% effect was exactly offset in our forecast by a +0.2% bonus for the unanticipated surge in fracking activity and the ensuing burst of momentarily cheap energy. So why the fuss? The resource debit merely reflects the remarkably odd GDP accounting that counts an unfortunate surge in necessary costs as a benefit, and the remaining 1.5% is merely reflecting recent data. Higher growth assumption, Mr. Bernanke should be aware, must prove longer-term improvements in productivity or, tougher yet, increased labor input.

In his note he adds a long paragraph about why it's so worrisome that the Fed hasn't adjusted to the realities of lower growth. Basically he argues that the Fed will blow more bubbles, thinking that the economy can be revved to a higher level than it actually can be:

This doesn’t really fit in with a quarterly letter emphasizing important good news, but being about the Fed, I have to make an exception. The Fed appears to be still assuming a 3% growth rate for future U.S. GDP. It would be safer and more confidence-inspiring, now that Bernanke appears to take his responsibility for growth seriously, that he at least have a reasonable growth target (preposterous as that notion is to me that the Fed should or even could affect long-term growth simply by messing about with interest rates). The growth in available man-hours has definitely declined by about 1% a year, yet Bernanke’s assumption for our GDP’s normal trend growth appears unchanged at its old 3%. Ergo, he must be assuming an offsetting rise of 1% in productivity. But why? We should treat these assumptions quite seriously for this is famously (for me) and painfully (for all of us) the man who could not see a 3¾-standard-deviation housing market, and indeed protested that all was normal, etc., etc., etc. (Dear handful of niggling readers, this 3¾-standard-deviation event is calculated on the assumption of a normal distribution, as is often done in investing, even though we [especially at GMO] know this is not true but is just a convenient statistical device. In fact, we at GMO know quite a bit more on this topic for we have studied more or less all assets for as long as we can find data and we have found a remarkable total of 330 “bubbles,” 36 of which we call “major, important bubbles,” which we define as 2-standard-deviation events, given the same assumption. Well, a 2-sigma event should occur every 44 years in a normally distributed world and they have occurred every 31 years. This is much closer to random than we had previously thought. Yes, financial asset data is fat-tailed; that is, there are more outlying events than are found in a normally distributed series, but they are not extremely fat-tailed. They show up as 2-sigma events but occur as often as 1.8-sigma events would occur in normal distributions. Extrapolating, we can assume that Bernanke’s 3¾-sigma housing bubble would occur, adjusted for our fat-tailed real-life history, not every 10,000 years, but somewhere more like 1 in 5,000 years! I previously used “a 1-in-1,200-year event” as a casually selected very large number to describe the 2006 housing bubble. But under challenge, these current numbers are more accurate. No, this does not mean we have 10,000 years of data or even 5,000. It is just statistics, full as always of assumptions, which in this case we hope approach rough justice. What it does definitely mean, though, is that it was extraordinarily unlikely that the extremely diversified U.S. housing market would shoot up like it did and, frankly, even more remarkable that Bernanke and his timid or incompetent advisors could miss it. This is a doubly amazing miss because his and Greenspan’s policy caused this bubble in the first place!) In comparison, his willingness to target an unrealistic 3% level for GDP growth is statistically a microscopic error, a picayune mistake. Unfortunately, though, in the hands of probably the most influential man in the global economic world, it is an extremely dangerous one. I like the analogy of the Fed beating a donkey (the 1% growing economy) for not being a horse (his 3% growing economy). I assume he keeps beating it until it either turns into a horse or drops dead from too much beating! Fine-tuning economic growth, an impossible job for the Fed anyway, is hardly likely to get any easier by badly overstating trend-line growth. It seems nearly certain, therefore, that the Fed will keep trying to whack the donkey for far too long. The likely consequences of this policy are, to be frank, over my head, but my colleague Edward Chancellor will address them briefly if I can nag him effectively.